This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 by Leonard W. Wang. All rights reserved.

Friday, July 20, 2007

Commodities for Individual Investors

The global economy has grown vigorously in recent years, and the prices of commodities have risen sharply. We all know about oil and gasoline prices. Gold, uranium, silver, corn, cattle, and soybeans have also seen significant price rises. Rising prices attract investors the way shiny objects attract magpies. Nowadays, some people see commodities as the next hot thing. Are they a good idea?

1. Commodities Futures Contracts. The traditional way of investing in commodities is to buy a futures contract. Some view these contracts as a way to make fast money because you can buy one for only a 10% downpayment, or maybe even less. If the contract rises 10% in value, you have a 100% return on your investment. But the reverse is also true: if the contract drops 10% in value, you just lost everything you invested. Further, it's important to understand the nature of futures contracts. You either commit to buy a fixed amount of the commodity at a predetermined price, or to sell a fixed amount of the commodity at a predetermined price. The contract will specify a date on which you have to fulfill this obligation to either buy or sell, called the settlement date. You are locked into the contract--you must buy or sell at the specified price on the settlement date. There is no exit. This is the kicker in commodities futures contracts. If you are in a losing position on the settlement date, you have to take the loss (which could mean forking over more cash in addition to your downpayment if the contract has dropped by more than the value of your downpayment). When a stock drops, you can hold onto it in the hope that it will rise again. When a commodities futures contract is a loser on settlement date, you are stuck with the loss.

Big players in the financial markets can have a hard time figuring out which direction commodities prices will move. Remember the hedge fund called Amaranth, which collapsed because it guessed wrong on the direction of natural gas prices? Individual investors have an even harder time figuring out where commodities prices will go. Some individuals have lost $1 million or more playing with commodities futures contracts. You should avoid them.

2. Stocks with commodities exposure. A safer way to invest in commodities is to buy stocks of companies that have significant interests in commodities. The oil companies are obvious examples. Their stocks have generally done well with the rise in oil prices. Of course, part of the return from investing in oil companies comes from the skill (or lack of skill) of its management and other factors. But if you're looking for a commodities play, oil companies and other natural resources companies are a much safer way to make that bet than a futures contract.

3. Mutual Funds and ETFs. There are mutual funds and ETFs that specialize in providing investors with a chance to profit from commodities by investing in a portfolio of companies with interests in commodities. Since these funds are diversified to some degree, they may be less risky than the stocks of individual companies. They are certainly safer than futures contracts. Of course, you must consider their fees and expenses, as you always would with any mutual fund or ETF.

4. Mattress Stuffers. If you flirt with survivalist tendencies, you can buy gold coins. The 1 ounce 24 carat coins issued by some nations provide a convenient way to own gold--there's the American Eagle, the Canadian Maple Leaf, the South African Krugerrand, and the Australian Nugget. All can be purchased for a little more than the spot (i.e., cash) price of gold in the wholesale market. Owning gold coins presents problems of storage and insurance. And you should buy from a reputable dealer because most people can't tell gold from a bunch of other substances. But if you think the end of civilization is near--or you just want the fun of having some gold to stare at--you can buy gold coins and stick them in your mattress, or in the closet along with your freeze-dried food, bottled water, portable generator, camping gear, compass, flint and steel, tomahawk, coonskin cap, and Pennsylvania long rifle.

Is it a good idea to invest in commodities? If you put a small portion of your portfolio (5% or maybe even 10%) into commodities, you might acheive a degree of diversification that could pay off. Remember, however, that commodities prices are notoriously difficult to predict, and the financial markets have seen long stretches of time when commodities were not winners. Numerous investors have done just fine without investing in commodities.

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